Friday, October 11, 2013

The path beyond the Silk Road

The Silk Road, an online marketplace that for the past two years facilitated online transactions of elicit goods including drugs, paraphernalia, digital goods, forgeries and many other shady products met its end last week. The feds shut it down, and the alleged founder (after reading the affidavit, I believe Ulbricht is the wrong man, more about that later) is currently being held in super-alcatraz. I read the news early that morning, and immediately did something that I thought would be really clever. I did what I did because I believed 2 things:

First, those of you who have been following Bitcoin probably know that the Silk Road was in many ways responsible for the early viability of Bitcoin. The website, which operated on the tor network only allowed transactions of things like marijuana, cocaine, ecstacy, psychadelics, pornography, fake IDs, etc. to take place in Bitcoin. Hundreds of millions of dollars worth of Bitcoin moved through the marketplace. For a long time, the Silk Road was a major part of the burning question enshrouding Bitcoin: fiat currencies are only as valuable as the goods and services one can trade them in for, and the Silk Road allowed users to trade Bitcoin for things they couldn't get anywhere else online. Even early adopters of Bitcoin like me had to acknowledged that for all of its legitimate applications, in the short term Bitcoin needed the Silk Road to survive and be taken seriously.

The image below is from presentation for my senior economics capstone on Bitcoin that I turned in early May of 2012.

The top chart shows the intra-daily price variance in Bitcoin (daily change in price), and the bottom shows the search density of the term "silk road'+Bitcoin" according to Google Trends. My intuition was that as the popularity of the Silk Road grew, interest in Bitcoin would grow as well, and that the Silk Road may have been responsible for the huge spike in price.

Even after the period in 2011 that this data covers, the Silk Road remained both a large player in the Bitcoin economy, and a common association for Bitcoin amongst those who sought to celebrate or demonize the currency.

Second, the early 2013 spike and crash in the price of Bitcoin showed that Bitcoin investors are a skittish bunch. Most Bitcoin followers knew that with the level of growth Bitcoin had enjoyed throughout early 2013, a correction was inevitable, but the severity of the correction had a lot of people thinking it was a collapse. The tumbling effect was clear, novice investors saw the initial drop (which was partially manufactured by directed attacks against exchange sites), and reacted to it thinking that the Bitcoin dream was over, and sold off their holdings, causing further drops. I held onto my coin through it, and across 2013 was still way ahead for it, but the episode illustrated that the market is still vulnerable to panic sell-offs.

And so, when I saw the news about the Silk Road biting the dust, it seemed obvious to sell off some of my Bitcoin in advance of the panic sell-off, and buy more at the trough. Clever, right? I mean, Bitcoin enthusiasts can insist all day that Bitcoin is more than a drug currency, but at present it's still dependent on it, right?

And even if the Silk Road seizure doesn't have an effect, the novice investors will react thinking it will, and the price will drop anyways. And this one could be severe, part of the reason people held Bitcoin through the first cash is that they knew it still had applications to buy goods and services. Selling seemed like a no-brainer.

I sold a few of my most liquid Bitcoins, the coins that happened to be sitting around on campbx.com and not in an offline wallet, at about $122. The chart below shows what happened to the price of Bitcoin in the ensuing days:

I bought a few coins when it was down near $100 (about half of what I sold off), and waited to see what happened from there. The result? Bitcoin is trading about $5 higher on CampBX today than it was before the Silk Road shut down.

If I had simply held my Bitcoin throughout the whole thing, I would have come out ahead by a few dollars. So much for my clever idea. Of note in the above chart, is that each sell-off didn't seem to beget more selling-off. The market didn't hit any kind of downward spiral like it did back in April, there were solid corrections in the opposite direction associated with every drop.

I think the memory of the last collapse may have contributed to the stability this time around. Last time every media outlet that had even mentioned Bitcoin in the past was tripping over itself to get the word out about the "Bubble bursting." It was a great story for them, a bunch of people poured their money into a glorified ponzy scheme and now it was all coming down. Money, confusing computerish thing, cautionary tale, check check check, journalistic gold.

However, Bitcoin was reluctant to play its role in that narrative. After the panic sell-off in April, some people thought Bitcoin was done for, they thought it better to sell their Bitcoin at $50 than to wait for it to hit zero. The prices discussed above show why that was a misguided strategy. A combination of long-term believers in Bitcoin holding onto their investments, and continued purchases of Bitcoin in order to buy goods (on the Silk Road and elsewhere) helped Bitcoin weather the storm.

So when post-Silk Road drop happened, Bitcoin investors weren't as quick to panic. The sky wasn't falling, it was just a little drizzle. I think this demonstrates the relative maturity of Bitcoin investors now, compared to 6 short months ago, in part because the panic sellers stayed out for good after last time, and also because those of us on the fence were reassured by the last rebound. At every trough on the chart above, there were enough people who saw an opportunity to buy back in.

But there's more to it than that. The fallout from the federal takedown of the Silk Road showed that it was more than just a website, it was a proof of concept, and at least for a while, it worked.

For one, most agree that Road founder Dread Pirate Roberts was taken down for his sloppiness. He was caught importing fake IDs from Canada that he allegedly planned to use to rent servers. It's a bit puzzling why he would import IDs and risk customs catching his illegal shipment (which they eventually did) when the Silk Road itself has US based sellers that also offered fraudulent identification.

Also, the Silk Road heavily encouraged customers and sellers to use PGP Encryption (the kind that at current computing standards would take a few millennia to decrypt without the password) to protect personal information, yet DPR allegedly left a mountain of evidence in plain-text messages including a request to have a Silk Road user assassinated. This level of sloppiness is why in part I believe Ulbricht may have been set up, but either way I think it's fair to say that even if the downfall of the Road was inevitable, this particular plague was avoidable.

And apart from Ulbricht, the fall-out seems pretty minimal. About $80 million worth of Bitcoin in user accounts is rumored to be hidden somewhere, but it doesn't look like many people will be going to jail over this.

More importantly, as a concept the Silk Road has certainly survived past its first iteration. This thread on the Silk Road Forums (.onion links only work through Tor browser) contains 17 pages worth of posts from former Silk Road vendors informing their customers of other websites where they will continue operations. Almost all of them are headed to either Sheep Marketplace or Black Market Reloaded, two former competitors of the Silk Road that are now tasked with becoming its successors.

It remains to be seen if Sheep or BMR can not only satisfy the demand for services that Silk Road met, but also improve upon its architecture to reduce the possibility of another takedown and seizure of funds. Part of the genius of Silk Road was in its tumbling/washing service. Recall that all Bitcoin transactions that ever occur are added to a long ledger called the blockchain, which keeps track of how many coins each wallet has available to spend. Generally, it's very easy to find out where the Bitcoin in a wallet came from. The tumbling service protected sellers by masking and obscuring the path of Bitcoin through the network, so that it wouldn't be clear to either party where the Bitcoin started and where they eventually ended up.

Beyond tumbling, there are other challenges that these spiritual SR-successors will have to meet, including robust enough security to withstand the inevitable onslaught of hacking attacks. But I think the fact that so many sellers have continued operations elsewhere showed that taking down one website was merely a battle in what is bound to be an enduring war.

So Bitcoin has recovered from the minor setback that the Silk Road shutdown created. Going forward, I think with the increasing maturity of the average Bitcoin investor, shocks like this will continue to decrease in severity. Further, the fact that the Silk Road concept, a major market application for Bitcoin has managed to live beyond its most successful implementation thus far does a great deal to assuage the fears of those that believe Bitcoin will one day suffer from regulatory pressure.